Alibaba Shows Gross Margins 2x to 3x Amazon's: How Long Can That Last?

Despite a strong quarterly report or that the company set a new record for Internet sales, MoneyShow’s Jim Jubakstill questions what will happen when this e-commerce company moves from being just a Chinese one to a global one.

The company followed up that strong quarterly report with a stunning Single’s Day on November 11. On China’s biggest Internet shopping day of the year, Alibaba reported gross merchandise volume of $9.3 billion, setting a new record. Sales had indeed blown through the old record of $5.8 billion, set last year, by 1:30 PM in the afternoon. On the day, Alibaba recorded 278.5 million orders.

But none of this startling success means that Alibaba has completely escaped the iron rules of Internet commerce that govern competitors such as Amazon.com (AMZN).

As e-commerce companies expand, racking up ever-larger sales volumes, so too do their costs grow. In its most recent quarter, Alibaba reported that it spent $550 million on data centers, land rights for warehouses and distribution centers, and construction. And there’s good reason to believe that this spending will increase and that Alibaba’s extraordinary gross profit margins will fall as it tackles the single biggest advantage and weakness of its business model: distribution.

Alibaba co-founder Jack Ma has made it clear what Alibaba—to this point—is not. “Alibaba helps others do e-commerce. We do not sell things.”

Up to this point, Alibaba has relied upon the merchants who sell through its e-marketplace to fulfill all those orders. In comparison to Amazon, Alibaba doesn’t own or operate very many warehouses or keep much (if any) merchandise in stock. The result is something very different from Amazon’s “Order in the next three hours to receive your goods overnight” fulfillment and delivery system. Orders to inland cities and towns in China can easily take 10-15 days to arrive. And because Alibaba doesn’t operate a unified tracking, delivery, and complaint system, customers are left without much recourse—except for an appeal to the merchant selling through Alibaba—if the merchandise they’ve ordered arrives damaged or an order is incomplete.

The question for Alibaba: How long can the company sustain that capital spending light model?

Certainly, rivals see it as a potential weakness.

Smaller rivals such as JD.com (JD) are building their own systems of warehouses and shipping their own goods. That company told the New York Times that it can provide same-day delivery in 100 cities now and next day delivery in 600 others.

For Single’s Day, Amazon began trial operation of a China-based site that sources 80,000 overseas products from Amazon’s US and European Web sites. Customers have three shipping options: standard for 9-15 days, expedited at 5-9 days, and priority in as little as three days.

There’s no question that Alibaba is feeling some heat from these efforts. The company has said it will establish warehouses at critical points that it will share with its logistics partners to streamline distribution.

But that’s a far cry from Amazon’s structure. From 2010 through 2013, Amazon spent $13.9 billion to build 50 new warehouses. Storing inventory, shipping, and delivery are Amazon’s top expenses and those costs have climbed by 40% annually from 2010 to 2012.

In the US, Amazon figures that all that spending is crucial to fending off online competitors such as eBay (EBAY) and the Internet operations of brick and mortar retailers such as Wal-Mart (WMT) and Target (TGT). Will that same logic hold in China? The country has a relative paucity of retail stores, so many Alibaba customers don’t have the option of walking into a store, making a purchase, and having their merchandise immediately.

Gross margins at Amazon—partly because of this distribution heavy model—were 28.9% in the third quarter of 2014. Alibaba’s gross margins in the just completed quarter were 73.6% and operating margins were 43.7%.

It is reasonable to think that Alibaba’s gross margins will come down with time as the company does have to spend millions—if not billions—to compete on logistics. But what’s important to Alibaba investors (as opposed to traders, speculators, and flippers) is where those margins settle. I doubt that they’ll fall to Amazon’s levels, but as Alibaba moves from being a Chinese e-commerce company to a global one, they will decline.

Watch what Alibaba spends as it breaks into the US and European markets for clues.